Stimulus Surprise: Companies Retrench When Government Spends

New research from Harvard Business School suggests that federal spending in states appears to cause local businesses to cut back rather than grow. A conversation with Joshua Coval. Key concepts include:

The average state experiences a 40 to 50 percent increase in earmark spending if its senator becomes chair of one of the top-three congressional committees. In the House, the average is around 20 percent.

For broader measures of spending, such as discretionary state-level federal transfers, the increase from being represented by a powerful senator is around 10 percent.

In the year that follows a congressman's ascendancy, the average firm in his state cuts back capital expenditures by roughly 15 percent.

There is some evidence that firms scale back their employment and experience a decline in sales growth.

by Sean Silverthorne

Recent research at Harvard Business School began with the premise that as a state's congressional delegation grew in stature and power in Washington, D.C., local businesses would benefit from the increased federal spending sure to come their way.

It turned out quite the opposite. In fact, professors Lauren Cohen, Joshua Coval, and Christopher Malloy discovered to their surprise that companies experienced lower sales and retrenched by cutting payroll, R&D, and other expenses. Indeed, in the years that followed a congressman's ascendancy to the chairmanship of a powerful committee, the average firm in his state cut back capital expenditures by roughly 15 percent, according to their working paper, "Do Powerful Politicians Cause Corporate Downsizing?"

"It was an enormous surprise, at least to us, to learn that the average firm in the chairman's state did not benefit at all from the unanticipated increase in spending," Coval reports.

Over a 40-year period, the study looked at increases in local earmarks and other federal spending that flowed to states after the senator or representative rose to the chairmanship of a powerful congressional committee.

We asked Coval about the relationship between the government and the private sector, and how policymakers should critically evaluate federal stimulus plans to help local companies.

Sean Silverthorne: First, a little bit about your empirical approach to the research. Why did you decide to study changes in congressional committee chairmanships?

Joshua Coval: Our original goal was to investigate how politically connected firms benefit from increases in the power of their representatives. A benefit in focusing on changes in committee chairmanships is that their timing is largely exogenous from the perspective of the ascending chairman and his constituents. That is, a change in chairmanship can only occur if the incumbent retires or is voted out--both of which are entirely independent of what is currently happening in the ascending chairman's state.

Q: One of your findings was that the chairs of powerful congressional committees truly bring home the bacon to their states in the forms of earmark spending. Can you give a sense of how large this effect is?

A: Sure. The average state experiences a 40 to 50 percent increase in earmark spending if its senator becomes chair of one of the top-three committees. In the House, the average is around 20 percent. For broader measures of spending, such
as discretionary state-level federal transfers, the increase from being represented by a powerful senator is around 10 percent.

Q: Perhaps the most intriguing finding, at least for me, was the degree and consistency to which federal spending at the state level seemed to be connected with a decrease in corporate spending and employment. Did you suspect this was the case when you started the study?

A: We began by examining how the average firm in a chairman's state was impacted by his ascension. The idea was that this would provide a lower bound on the benefits from being politically connected. It was an enormous surprise, at least to us, to learn that the average firm in the chairman's state did not benefit at all from the increase in spending. Indeed, the firms significantly cut physical and R&D spending, reduce employment, and experience lower sales.

The results show up throughout the past 40 years, in large and small states, in large and small firms, and are most pronounced in geographically concentrated firms and within the industries that are the target of the spending.

Q: Although you didn't intend to answer this question with the research, what does your team suspect are some of the causes that could explain why companies retrench when federal dollars come into their neighborhoods?

A: Some of the dollars directly supplant private-sector activity—they literally undertake projects the private sector was planning to do on its own. The Tennessee Valley Authority of 1933 is perhaps the most famous example of this.

Other dollars appear to indirectly crowd out private firms by hiring away employees and the like. For instance, our effects are strongest when unemployment is low and capacity utilization is high. But we suspect that a third and potentially quite strong effect is the uncertainty that is created by government involvement.

Q: These findings present something of a dilemma for public policymakers who believe that federal spending can stimulate private economic development. How would you suggest they approach the problem that federal dollars may actually cause private-sector retrenchment?

A: Our findings suggest that they should revisit their belief that federal spending can stimulate private economic development. It is important to note that our research ignores all costs associated with paying for the spending such as higher taxes or increased borrowing. From the perspective of the target state, the funds are essentially free, but clearly at the national level someone has to pay for stimulus spending. And in the absence of a positive private-sector response, it seems even more difficult to justify federal spending than otherwise.

Q: What do you think your research has brought to the literature?

A: The literature has had difficulty empirically identifying the effect of government spending on the private sector. Because spending both influences and is influenced by developments in the private sector, disentangling the two has proven challenging. We think our approach offers a rare opportunity to identify the private-sector response to government spending increases that are essentially random.

Q: What are you working on next?

A: Our next project will be to ask a similar question of the private sector: Does private-sector economic activity create or crowd out additional private-sector opportunities? Put differently, did Bill Gates's decision to relocate Microsoft to the Seattle area in 1979 increase the likelihood that Amazon.com, Starbucks, and Costco would emerge from there a decade or so later? If so, this has strong implications for policymakers interested in, say, improving Detroit's economic prospects.